Time to Set Sail with Carnival?

Stone Street Advisors

Jan. 21, 2012, 9:34 PM

Television screens and newspapers have been inundated by pictures of Costa Cordia listing off the shore of the island of Giglio. While this is a PR nightmare for Carnival Corporation & plc (NYSE: CCL), could it be an opportunity for intrepid investors? On Tuesday, the first day the US shares traded after the ship ran aground, the shares tumbled 13.7%. With 780 million shares outstanding, the drop equaled $3.7 billion in market capitalization. On that day, I tweeted that the sell-off was overdone. The shares have since recovered 6.6%. Did you miss the boat? To find out, read on.

After the tragic incident, the company quickly came out to quantify the damage. On Monday, CCL issued a press release stating that the financial impact of the grounding was expected to be $85 - $95 million or $0.11 - $0.12 per share. In addition, the company said that it anticipates "other costs to the business that are not possible to determine at this time." Analysts who follow the stock seem to believe those other costs are approximately $0.14-$0.15 per share. Full year estimates are now $2.43 down from $2.70 just one week ago. This suggests that the total cost of the incident will be $210 million. At the current price of $31.56, the stock is trading at 13.0x 2012 and 11.3x 2013 estimates. This is up from 12.7x and 11.1x for 2012 and 2013, respectively, before the accident. The multiple is roughly in line with the S&P which currently trades at 12.7x 2012 and 11.5x 2013 earnings.

As an investor, the goal is to protect the downside. The question to ask is what are the unknown costs the company could face? Environmental damages are the largest unknown. Thus far, the fuel recovery appears contained. However, if the situation does take a turn for the worse, who pays? The U.S. Oil Pollution Act of 1990 requires companies to demonstrate the ability to meet the maximum amount of liability to pay for removal costs and damages related to water pollution. In the 10K, the company states that its responsibility is covered by insurance.

There are likely to suits arising from the loss of life. This is no small matter, to date, there have been 11 confirmed deaths with 20 still missing. The downside related to potential suits is covered by the company's Protection and Indemnity insurance. Moreover, the company has distanced itself from the Captain of the vessel and is now claiming to be an "injured party" (steering of these ships is designed to be almost fool-proof). While insurance costs may increase going forward, as the largest and financially the strongest cruise line, any increase should be manageable.

There is always the potential for lost business. As we seen in the past, despite food poisoning and power outages stranding passengers at sea, the general public still has a fascination with sailing the open waters on larger and larger ships. After all, people didn't stop going on cruises after the Titanic went down. There was even a recent report that suggested bookings are still coming in despite the accident.

What do the numbers say? Since 2007, available berths on CCL ships grew at a compound annual rate of 6.3%. During that same period, net revenue per available berth has gone from $188.46 in 2006 to $179.33 in 2011. In 2008, net revenue per available berth hit a high of $195.46 then dropped to $168.94 in 2009. The average over that period was $180.83. The 10 year average is $175.46. With the number of berths slated to slow, the potential to increase the dollars per berth above the five year average and closer to the highs seen in 2008 (a 9% increase) seems reasonable.

EBITDA over the past 5 years dropped from $3.83 billion in 2007 to $3.79 billion in 2011. In 2008, EBITDA reached $3.944 billion then fell 12% to $3.46 billion in 2009. Further, the EBITDA margin has fallen to 24.0% last year from 29.4% in 2007 - averaging 26.6% over that time. The EBITDA margin has been as high as 31.3% in the last ten years. For those that believe in reversion to the mean, margin expansion of 260 basis points would add $403 million to EBITDA an increase of 10.6%.

The stock, as of Friday's close, yields 3.2%. In 2011 the payout ratio was 35%. With the stable EBITDA, a relatively low payout ratio and fewer ship additions expected, the potential for a dividend increase is significant. In addition, the company has repurchased $2.2 billion of stock in the past five years which is equal to 10% of the current market cap. This demonstrates that management is willing to return excess cash to shareholders.

The stock is down 34% since this time last January. EPS in 2011 was 83% of peak earnings from five years ago. The stock is trading at a slight premium to its book value of $29.04 which should provide additional downside protection. Finally, lowered earnings expectations provide the potential for an upside surprise which could lead to multiple expansion and better returns for intrepid investors seeking to pick up an industry leader on the cheap.

Full disclosure: I have no position in the stock but may purchase shares in the next 72 hours. As always I welcome and encourage your feedback.